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Thoughtful advice on how to manage your money

Extended Duration Treasuries

I am back. Sorry for the long hiatus.

My last entry discussed extended duration treasuries and their role in a portfolio. If you have been listening to financial industry experts and commentators during the spring and summer you may have been inclined to avoid mid to long duration treasuries. Some commentators have even suggested that you avoid bonds altogether and load up on dividend paying stocks or stocks with a history of increasing dividends.

I am not one to dissuade investors from investing in defensive stocks, high dividend stocks or stocks that regularly appreciate their dividend payout. However, discouraging people from owning bonds and especially treasuries in an environment that is at best volatile and at worst deflationary is bad advice. In mid July when I discussed EDV (Vanguard Extended Duration Treasuries ETF) the price was $82 per share. Today the price is close to $118 that’s a 44% increase in about 5 months. No other asset type has even come close to such a performance. These bonds pay just over 3% and have an average duration of 27 years.

If you have benefited from my advice and made  a 44% return on EDV then congratulations. But, one thing should be clear before you assume I am a “genius” and start expecting regular tips that will perform in spectacular fashion – I did not know that EDV was going to out perform other assets when I wrote to recommend that investors hold some in their portfolios. I was merely suggesting EDV as insurance against a downturn in the stock market. Keep in mind that EDV is very volatile but it moves in the opposite direction to stocks. What is surprising is that the level of appreciation has been much more than the decline in stocks. I think it may indicate the level of fear investors have in the current market valuation.

Investors should not purchase EDV at this time. The price is very high. I would wait until it is at or below $100 per share.

The debt ceiling and US treasuries

The August 2nd deadline for increasing the debt ceiling is fast approaching. If the debt ceiling is not increased, the US will be in unchartered territory. The US government taxes and borrows to fund its operations. With the ability to borrow abruptly stopped, it is possible that some checks such as Social Security, Medicare, Medicaid, and unemployment compensation will not be paid. Even if the debt ceiling is raised the rating agencies will most likely downgrade US government bonds from AAA to AA. Ultimately, the US government will pay its obligations but the damage to the US credit rating has already been done. As a result of the political theater we have witnessed in the pass few weeks, US debt will be downgraded for the first time in history.

What should people do? It is difficult to know what, if anything, should be done. A few weeks ago, I wrote about Extended Duration Treasuries. I recommended that those who want a hedge against a market downturn should consider holding an ETF such as EDV which is made up of long-term treasuries. Ironically, these US government obligations, are likely to go up in times like these. When treasuries were considered default free (that is what a AAA rating means) investors rush to them as the last resort to safety. Many wonder if the downgrade will affect the “safe haven” status. I think not. There are no alternatives. The Euro denominated debt is riskier and gold if very hard to asses especially at the current peak price at more than $1,600 per ounce. Last week the market dropped by close to 4%. By contrast, EDV moved up by 3.32%.

I am not suggesting that investors should rush and purchase treasuries in large amounts because of what might happen next week or next month. We believe that investors should have a long-term view and not react to market movements on a short-term basis. Investors who have not built a diversified portfolio should read the investing section of this blog, and build a portfolio tailored to their needs. Within an investor’s portfolio, funds like EDV can play an important role as a hedge against market downturns. At least while there is no alternative US treasuries.

I-Bonds

 

In this low yield environment savers have a tough time finding low or no risk return over 1%. I-Bonds offer the best alternative for savers these days.  The current rate is 4.6% through October 31, 2011. The maximum purchase per year per person is $10,000 ($5,000 online from TreasuryDirect and $5,000 from your bank). The interest on I-Bonds is has two components: a fixed rate and a variable rate base on the CPI-U (consumer price index for urban consumers). This bond is basically a hedge against inflation and if you buy now before the rates are adjusted on Nov. 1 you will get the 4.6% for the next 6 months (effectively 2.3%).

Here are additional facts on I-Bonds:

  • You can redeem them at any time after a twelve-month minimum holding period
  • Interest, if any, is added to the bond monthly and is paid when you redeem the bond
  • I Bonds are sold at face value; i.e., you pay $50 for a $50 I Bond
  • I Bonds grow in value with inflation-indexed earnings for up to 30 years
  • If you redeem I Bonds before they’re five years old, you’ll forfeit the three most recent months’ interest; at or after 5-years old, you won’t be penalized

I-Bonds can earn zero percent in a deflationary environment but the holder is guaranteed his/her principle.

Save on health care

HC savingsA new type of primary health care service is now available in some parts of the US. The organizations that provide the care do not consider themselves insurance companies. Some refer to them as “direct primary care providers.” You can think of them as health membership companies. What is the main difference? Cost. If paying under $260 per month for a family of 4 sounds good to you, then read on…

I will discuss 4 care providers operating in different parts of the country. There may be more in other markets. If you know of one in your area, please let us know about it.

These organizations provide primary care and some offer discounts on medications, imaging, and lab work. No one is refused care on the basis of a pre-existing condition. There are no co-pays and you can have unlimited visits.

You will still need to purchase supplemental “Catastrophic Care” to cover major accidents that will require major surgery/hospitalization and the like. The supplemental care will likely have a high deductible such as $7,500 per person and a monthly fee of $100 to $300 per person (sometimes more).

If you live in the Seattle area consider joining Qliance. They offers two care plans: QL1 and QL2. You pay a one-time $99 fee per family to join and a monthly fee after that. The QL1 fees range from $49 for a child to $89 per month for a person over age 65.

QL2 starts at $54 for ages 14 to 19 and goes up to $129 for someone 65 or older. What you get is access to a primary care physician and the typical service with any primary care plan (See Plans for more details). Referrals to specialists are also included.

People who have switched to Qliance say the level of care is the same or better than with traditional health insurance plans they had. To find out more, see Yelp for reviews.

If you live in the Monterey and San Jose area of California, consider joining MedLion. The one time enrollment fee is $50 for a family (no matter the size). The monthly fee is $49 per person per month. Each visit is $10 (see Fees.)

You get the typical primary care package with additional discounts on lab studies and imaging.

If you live in the Bloomfield, NJ area, take a look at what Symbeo has to offer.

Access Healthcare serves the Apex North Carolina area.

Extended Duration Treasuries

Most of us have been affected by the financial crisis of 2008. There are reasons to fear a double dip recession globally and in the US. If you are interested in hedging your portfolio against a future crisis and the resulting steep decline in stocks, consider allocating some of your investment money to the Vanguard Extended Duration Treasuries ETF (EDV).

This fund is made up of very long-term US treasury bonds (20 to 30 years). Because of the long maturity of these bonds they are extremely sensitive to interest rate risk. So this ETF is considered “high-risk.” Indeed it has a high standard deviation (about 28.7). That’s more like a stock fund than a bond fund. However, this fund’s returns have a negative correlation to the stock market returns. This means, the fund’s value goes up when the stock market goes down and vise-versa (see the chart below).

GenerateStockChart.ashx_

The red line shows the returns of the Vanguard Total Stock Market Index (VTSMX) fund, the yellow line shows the returns of the Vanguard Total Bond Market Index (VBMFX) fund and the blue line shows the returns of the Vanguard Extended Duration Treasuries ETF for the past 4 years. As you can see EDV’s price is clearly negatively correlated to the stock market price. This is due to investors fleeing the stock market (and even bonds) to what is considered the safest securities US treasuries. These bonds are considered to have zero risk of default since the US government has never defaulted on its bonds. The yield on this fund is currently 4.25%.

Few caveats about EDV

1) Vanguard says “the fund is primarily intended for institutional investors with extremely long-term liabilities—20 years or more. Prospective individual investors are urged to consult with their own advisors to determine if the fund is suitable for their overall investment programs and financial positions.”

2) Note that EDV did not outperform Vanguard Total Bond Index (VBMFX) during the 4 years it has been in existence. So again the object of this fund is first and foremost as a hedge for those concerned about a repeat of the 2008 steep decline in stocks. Secondly, this fund has a high yield consistent with its very long duration.

3) Morningstar does not like this fund. It gives it a single star. I believe Morningstar is rating EDV against other bond funds and not as a hedge against stock declines. While they do provide a rating for EDV they do not have analyst commentary for it.

4) If and when interest rates rise this fund will suffer more than bond funds with shorter durations (see bond mutual funds).

5) Finally, just because the fund performed well thus far as an instrument with a negative correlation to stocks this does not mean that it will always do that. If investors start doubting the US government’s ability to reduce its debt this might change.

Finally, EDV (or a similar long-US Treasuries fund) is a good fund to own in the range of 3% to 5% of your portfolio as a hedge against steep stock declines. In other word this is not a core holding but a fund that will play a good supporting role in a well balance portfolio.

Introducing MoneyConfidence.com

Welcome to MoneyConfidence. This site seeks to present insights and intelligent tips on how to manage your money, what you can do to grow it more effectively, and other recommendations. This site was started by 2 Seattle neighbors, both MBA's. Between the two of us we have many years of experience working in the fields of banking, finance, and technology.

The following is a brief description of each of the sections on offer in this site:

Banking

  • News and information on industry practices and services.
  • Getting the best rates on savings, CDs, and loans.
  • Avoiding fees and scams.

Debt and Credit

  • Information and resources on managing debt and improving credit scores.
  • What type of debt to avoid and which type to keep.
  • How to improve your credit scores and minimize score penalties.
  • Where to find debt and credit counseling.

Investing

  • A  guide to lifelong investing, resources and advice on investment choices.
  • Types of investment accounts and their tax implications.
  • Risk and reward information for various investment choices.
  • Do-it-yourself knowledge that is simple and effective.

Spending and Saving

  • Advice on how and where to save money.
  • Budgeting and other cost management tools.
  • Resources to save you money and time.

Quick answers to some financial questions

Where can I find a good credit card?
http://www.creditcardguide.com/

I need a loan calculator.
http://www.dinkytown.net/loan.html

I need a mortgage calculator.
http://www.dinkytown.net/mortgage.html

Do I need life insurance?
You need life insurance if your death will cause hardship for someone else. If you think your family will manage fine without additional funds to replace your lost income then do not do it. More here.

How should I invest for the future?
Start here.

I am risk averse should I own stocks?
Anyone with a time horizon of 5+ years should own stocks along with other asset categories. Not owning stocks could keep you from beating inflation. The key is to make sure you invest in domestic and foreign stocks with limited exposure to small and mid size companies.

I have a high tolerance for risk; should I own bonds?
Yes. Every portfolio needs exposure to bonds. Between 2000 and 2010 bonds beat stocks. Owning bonds will reduce the overall volatility of your portfolio.

I am looking for a single moderate to conservative investment choice?
Here are two of my favorite balanced funds:

Vanguard Balanced Index Fund (VBINX) is also a good balanced fund.

How can I gain wide exposure to the stock market?
The Vanguard Total World Stock ETF (VT) gives you instant exposure to the global stock market at an incredibly low price of 0.25%!

What are target date retirement funds? Should I own one?
Target date retirement funds are balanced funds that investors can purchase and hold until retirement. Usually the manager will reduce the stock (or more volatile assets) and increase bond holdings (or the less volatile assets). These funds are a good choice for people who seek to own a single fund and do not want to bother with building their own portfolio. I will have more to say on this subject in the near future.

What is an IRA?
IRA stands for “Individual Retirement Account.” This type of account is intended for retirement saving / investing. See the investment accounts sections for details.

What is a ROTH IRA?
One key difference between a ROTH and a traditional IRA is the tax free withdrawal benefit for the ROTH. On the other hand you cannot add pre-tax money to a ROTH IRA but you can with a traditional IRA. See the investment accounts sections for details.

What kind of mortgage should I choose?
The 30 year fixed mortgage remains the best choice for most people. It has the following advantages:

  1. A predictable fixed payment for the 360 months duration of the loan;
  2. Lower payments than a 15 year loan;
  3. Lower interest than a fixed interest only loan;

More on this subject here.

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